Journal of Finance and Economics, 2014, Vol. 2, No.

3, 60-66
Available online at http://pubs.sciepub.com/jfe/2/3/1
© Science and Education Publishing
DOI:10.12691/jfe-2-3-1

Income Distribution in Multinational Firms through

Transfer Pricing
José G. Vargas-Hernández*

Lic. Belisario Valencia-Sepúlveda, Centro Universitario de Ciencias Económico Administrativas, Universidad de Guadalajara,
Zapopan, Jalisco, México
*Corresponding author: jvargas2006@gmail.com; jgvh0811@yahoo.com; josevargas@cucea.udg.mx

Received March 02, 2014; Revised March 11, 2014; Accepted March 16, 2014
Abstract The objective of this paper is to analyze the procedures used by multinational enterprises to distribute
the income generated by their subsidiaries abroad. Also, the paper intends to answer the question how multinational
firms allocate taxes paid on this income among the fiscal jurisdictions in which they operate. In this study, the
analytic research method was applied, by revising the available literature in order to determine how income-shifting
works, as a fiscal strategy applied by MNEs. It is concluded that MNEs use organizational strategies to take
advantage of the comparative advantages of the different countries in which they operate, and, as a result, an
intercompany trade takes place.
Keywords: multinational firms, transfer pricing, income shifts
Cite This Article: José G. Vargas-Hernández, “Income Distribution in Multinational Firms through Transfer
Pricing.” Journal of Finance and Economics, vol. 2, no. 3 (2014): 60-66. doi: 10.12691/jfe-2-3-1.

Multinational firms should be required by national and

1. Introduction
The increase in the number of multinational firms
operating in the international economy has led to a greater
dynamism in the inter-firm trade. Multinational firms have
the purpose to provide goods and services of equal value
and quality in relation to price to consumers and
costumers as the primary claimants around the world,
regardless of their personal characteristics, nationality,
ethnic origin, or religious creed. Intrafirm transference of
prices between the different subsidiaries is determined by
the flows of raw materials and commodities plus the
logistics costs derived of locations. Taxation rates on
foreign investments of multinational firms play a crucial
role in alternative locations choices (Devereux and
Griffith, 1998). Inter-firm commerce is sustained on a
shared production scheme with artificially established
export prices to favor transference of earnings to the home
country while jobs created are subsidized by the host
country economy.
That situation has forced the tax authorities of the
jurisdictions in which these companies operate to
implement more stringent regulations on transfer pricing
in order to avoid shifting income to lower tax rate
jurisdictions. About this, Robbins (2002) notes that
although international businesses have been around for
centuries, multinational firms are relatively a recent
phenomenon. They are a natural result of the global
economy. Multinational firms use their operations around
the world to develop global strategies. Rather than confine
themselves to their domestic borders, multinational firms
search the world to find competitive advantages.
global institutions to fulfill policies regarding
accountability, and, transparency, on some relevant issues
such as profits, taxes, etc.
Multinational enterprises are defined as firms operating
with foreign direct investment (FDI); they directly control
and manage value-added activities in other countries
(Peng, 2010). It is assumed that foreign investments
should be highly responsive to local differences in the
investment climate, institutional financial arrangements,
and rates of return, taxes and other regulations and labor
costs. In the last years, foreign direct investment has
grown in less developed countries, attracted by tax
incentives, environmental flexibility and some other
advantages offered by cheap labor, etc. There are several
variables considered as determinants of FDI such as
macro-economic stability, labor costs, corporate taxation,
corporate governance, cultural and language features, etc.,
variables which are considered in the context.
Multinational firms can be regarded as important factors
in globalization process.
Governments compete to attract multinational firms,
hoping to increase tax revenues, create jobs and stimulate
economic activity. In order to attract FDI, governments
offer incentives to multinational firms such as tax
exemptions, government support agreements, grant
infrastructure, or lax environmental and labor regulations.
Among the contributions that foreign-owned companies
have to demonstrate are the inward flow of foreign capital
and technology, tax and balance of payments contributions,
spillovers on local business and communities, rate of
employment rise, improvement of competitive advantages,
etc.
61 Journal of Finance and Economics
Other variables may be considered for location choices
in international markets, such as, corporate taxation.
Foreign capital restrictions are not significantly related to
the taxation levels. Multinational firms are likely to deter
their operations in that location where the corporation
taxation is high, unless the after-tax rate of return of
investments is also high (Mooij and Ederveen, 2003).
Robbins (2002) notes that managers of multinational
firms face a very wide range of challenges in areas where
they operate, such as, different political systems, laws,
cultures, and, customs. However, these differences may
originate both problems and opportunities. For example,
currency devaluations of the Mexican peso lower export
prices and raise import prices, and, provoke the adoption
of direct protectionist formulas, which may cause some
important effects on trade adjustments, and, induce FDI
reshuffles.
One of the challenges facing governments and
multinational firms is that about tax collection due to
multinational enterprises operating in multiple tax
jurisdictions that have different rules, regulations, policies
and procedures. Thus, multinational corporations cannot
be considered as an isolated unit but as a group of firms
operating in a complex international environment. An
important aspect of multinational firms is the inter-firm
trade. Durán and Ventura (2003), define intercompany
trade and commerce that which takes place within
companies under the same organizational structure and
ownership of capital, between parent and subsidiary or
subsidiaries, or, between the subsidiaries and affiliates.
This situation places multinational firms in a favored
position. A key reason why the intercompany trade differs
from trade of full competence results from the fact that
multinational business can alter their transactions to
minimize their tax burden around the world. For example,
firms may use transfer-pricing techniques that allow them
to shift profits to jurisdictions with low tax rates and thus
minimize their overall tax burden (Clausing, 2000). The
price at which the parties exchange goods or services
related is known as Transfer Pricing. Guidelines
Applicable to Transfer Pricing and Multinational
Enterprises Tax Administrations of the Organization for
Economic Cooperation and Development ("OECD") states
that the transfer prices are significant for both tax payers
and tax administrations because that largely determine the
income and deductions, and therefore the tax base of the
associated companies operating in different tax
jurisdictions (OECD, 1993).
More than 60 governments have adopted regulations
regarding transfer pricing. Regulation of transfer prices
are based on full competence principle known as "arm's
length principle", (Wikipedia2012). This means that the
transfer prices of goods and services on intercompany
transactions must be based on an analysis of prices agreed
in comparable transactions between two or more unrelated
parties in a fully competitive market. In the case of
Mexico, the institution responsible for compliance with
these regulations is the Tax Administration Service
(Servico de Administración Tributaria, SAT), the rules
and regulation applicable to transfer pricing are described
in Articles, 86, paragraphs XII, XIII and, 215, 216,216-bis
and 217of the Law on Income Tax of Mexico (Ley del
Impuesto sobre la Renta, LISR). Article 216-bis of the
Income Tax Law refer to the special rules applicable to
companies in the maquiladora industry. In addition, as part
of the tax, report issued by the external auditor should
reveal the transactions carried out with related parties
abroad, and answer the questionnaires concerning the
revision of taxes.
This paper analyzes the organizational strategies
employed by multinational firms around the world in
order to exploit the competitive advantages of host
countries. In particular, the tax regulations applicable to
transfer pricing to minimize their tax burden by placing
income in tax jurisdictions with lower tax rates. This is in
response to different tax rates observed within the member
countries of OECD.
This document is divided into the introduction and four
sections. The next section reviews the economic literature
available in relation to the phenomena of multinational
firms, international production, intercompany trade, and,
relevant aspects of transfer pricing. In this same section
also, all this information is put in the framework of the
institutions based theory. The second section presents
three types of organizational strategies that correspond to
the evolution of multinational firms. These strategies give
rise to intercompany trade. The third section presents a
discussion of the problems faced by multinational firms
and tax authorities to determine the taxable base and the
application of transfer pricing methods to determine that
the intercompany transactions are agreed on the principle
of full competition. Finally, in the fourth section, the way
in which multinational enterprises can minimize their tax
burden through transfer pricing is illustrated.
This paper intends to analyze the income distribution in
multinational firms through transfer pricing. To achieve
this aim, first it reviews the theoretical framework of inter-
firm trade and transfer pricing. Second, it describes the
different organizational strategies of multinational firms
related to multinational firms transfer pricing and taxes
and examine minimizing tax burden through transfer
pricing to finally conclude that organizational strategies of
multinational firms generate inter-firm trade across
borders, so that multinational firms are forced to agree a
transfer price to exchange goods and services.
2. Inter-firm Trade and Transfer Pricing:
A Review of the Theoretical Framework
In order to explain the phenomenon of multinational
firms is necessary to start by reviewing the classical
theories of international trade, which have their origin in
the Adam Smith theory, and, the absolute advantage and
comparative advantage theory of David Ricardo, which
were systematized by Eli Heckscher and Bertil Ohlin. The
Heckscher-Ohlin model states that countries export
products that use their abundant and economic factors of
production and import products that use scarce factors of
production in the country. During the 1970s, emerged the
"new trade theory" addressing issues of trade
specialization, and also the location of productive
activities in different countries and regions (Helpman and
Krugman, 1985).
As for research related to inter-firm trade, Durán and
Ventura (2003) argue on the interest of economists
associated to inter-firm trade in relation to international
production, mainly to the impact of multinational firms in
 Journal of Finance and Economics
the international distribution of income, and tax issues
arising from transactions between related companies. The
research was focused on explaining the
internationalization of production and its relationship with
FDI. Among the most prominent studies are included:
Vernon (1996) studied the life cycle of the product. The
issue of internationalization of production is discussed by
authors such as Hymer (1976), Kindleberger (1990),
Caves (1971), among others. In these works the concern is
for inter-firm trade that appears as a side issue.
However, the Japanese researchers, Kojima and Ozawa
(1984), based on the Japanese experience, suggested that
FDI would be an efficient conduit of trade in intermediate
products between the companies involved and those on
investment (subsidiaries) that can benefit from
comparative advantages complementing the activities of
their parent companies. As for the research on transfer
pricing, transfer of goods, technology and services
between related parties located in different countries, it is
suggested that the price agreed in such transactions within
the multinational firms, is set based on various conditions
determined by company management (Durán and Ventura,
2003). Early studies in this line were those of Cook (1955)
and Hirshleifer (1956), followed later by Horst (1971),
and Itagaki (1982). These works share the concern that the
transfer prices erode the tax bases of host countries.
Moreover, from the point of view of the leader
strategies on strategy, institutions based vision, provides a
framework within which to develop this work. It starts
from the definition of institutions provided by North
(1990), who defines institutions as humanly planned
constraints that structure political interaction, and,
economic and social development. They consist of
informal institutions (sanctions, taboos, customs,
traditions and codes of conduct), and formal institutions
(constitutions, laws, property rights). An institutional
constraint such as formal and informal rules, affects
entrepreneurship, although this entrepreneurship
flourishes around the world, their overall development is
uneven (Peng, 2010: 130). The institutions-based vision
can help to explain how taxes affect intercompany trade
patterns of multinational firms and explain the fact that
multinational enterprises invest in subsidiaries around the
world in order to exploit the comparative advantages of
different countries.
3. Organizational Strategies of
Multinational Firms
According to the United Nations Conference on Trade
and Development (UNCTAD), the ability of multinational
firms to contribute to international economic integration is
a result of their own attributes and how they respond to
the political environment and economic context in which
they operate (UNCTAD, 1993). Mexican multinationals,
(large and medium size businesses), operate in many
different industries using their organizational and
technical capabilities and competencies to develop and
deliver market-based products and services that meet the
needs of local consumers.
To achieve these tasks, Mexican multinationals design
and implement strategies to create scale and scope
economies; engaging in strategic alliances, joint ventures,
62
partnerships, and associations with other partners, NGOs,
community developers, supply and distribution chain
partners; leveraging logistical networks; decreasing prices;
removing and liberating market constraints, etc., (Rangan,
Quelch, Herrero and Barton, 2007, UNDP, 2008).
Strategies of multinational firms evolve as they respond to
various pressures, challenges and opportunities, among
which we can mention the advances in information and
communication technologies, convergence of
consumption patterns around the world, intensifying
competition and opening markets, etc.
Some markets in developed and developing countries
are expected to tighten in the next following years due to
increased price competition and consolidation among
manufacturers, leaving Mexican multinational firms to
seek out new markets in other developing and emergent
economies. CEMEX operated in a highly protected legal
environment and no significant competition on price until
the 1990s and controlled 65 percent of the market shared.
Other good example is the recent success of Wal-Mart,
with its proprietary distribution sites and aggressive
supplier price targets, has helped alter the retail food
landscape and set new competitive standards. With no
value added tax on food, the efficiencies have had impact
across the supply chain and have been passed on as lower
prices to consumers (Goldstein, 2007).
One important lesson to be learned by multinational
firms is to manage price strategies to improve their market
performance in less developed economies through the
scalability of innovations and by discarding traditional
approaches to price-performance improvements. These
new strategies involve significant changes in the way that
production is organized across borders, which has led
multinational firms to locate a wider range of value-
generating activities abroad (UNCTAD, 1993).
Under the strategy of vertical expansion, the
multinational firms exploits a comparative advantage in
terms of production factors and prices, etc. by locating
intangible assets and human resources in foreign
economies, either through a backward vertical expansion
to procure production and distribution of a raw materials,
inputs and components, or through a forward vertical
expansion by distributing and selling goods and services.
Vertical foreign investment encourages multinational
firms to undertake foreign production in order to give
more certainty to supply and asset specificity.
Multinational corporations operating in low income
market segments are consciously cost management
systems oriented for innovation, organization,
manufacturing, distribution, etc., to achieve a competitive
price performance, capital efficiency and sustainable
profits. NAFTA has resulted in reallocation effects of
productive sectors based on relative prices changes, with
very poor impact on the performance at firm learning level,
technical inefficiencies and lack of innovation. Below,
three types of organizational strategies are presented,
described in the World Investment Report published by
UNCTAD (1993), corresponding to the evolution of
multinational firms. All these organizational strategy can
result in inter-firm trade.
A. Strategy of party autonomy
This strategy consists in establishing subsidiaries
operating independently in the host countries. The main
link between the parent and its subsidiary abroad is by
63 Journal of Finance and Economics

controlling shareholder. Other relationships may include
technology transfer and provision of long-term capital.
The parent company exercises little control over the
subsidiary, while it is profitable. In general, an
independent subsidiary is responsible for most of the
generative process of production value, through which
develops relationships with local suppliers and
subcontractors. It also employs local workers and
managers, conducts its financial transactions with local
financial intermediaries, and may participate in
international trade with other countries. Companies can
control many natural autonomous subsidiaries, each one
serving at different host country (UNCTAD, 1993). An
independent subsidiary can be seen as a replica of the
parent (multinational firm) in its new location.
According to UNCTAD (1993), there are three
organizational strategies that the multinational firms can
perform. The evolution of strategies performed by
multinational firms can be schematically shown in the
following diagrams (See Figure 1).

Figure 1. Strategy: autonomy of parties

Source: UNCTAD (1993). World Investment Report 1993, Transnational Corporations and Integrated International Production, New York, No.
E.93.II.A.14 Graphic V.2, p. 119.
B. Outsourcing strategy (Outsourcing)
Some multinational firms participate in international
production through subcontracting (outsourcing). The
activities in host countries are linked to processes
performed in other territories, mainly in the countries of
origin of multinational firms (Figure 2). In the case of
services, some multinational firms use foreign affiliates or
subcontractors to process information or develop software.
Services have become tradable due to technological advances
in computing and communication (UNCTAD, 1993).
The international outsourcing of production represents
the transfer of value generating activities in territories,
other than the country of origin of multinational firm.
Also this transfer of value may be different than other in
end-user countries where the products are destined. The
principal reason for outsourcing is to exploit the
comparative advantages of host countries. Production is
controlled by the multinational firms through stock
controls or through contracts with local firms, which
allows the multinational enterprises to concentrate in some
certain parts of the value chain, while the subcontractor is
specializing in the production, or other intensive labor
process (UNCTAD, 1993).

Figure 2. Strategy of subcontracting or outsourcing

Source: UNCTAD (1993), World Investment Report 1993, Transnational Corporations and Integrated International Production. New York, No.
E.93.II.A.14 Graphics V.3, p. 120.
C. Complex integration (Integrated Production Systems
International)
For some multinational firms, international production
can occur almost anywhere in the value chain. The
complex integration strategy is based on the firm's ability
to locate their production, or supply of resources, where
more profitable. Under the complex integration strategy,
any subsidiary operating in any territory can perform for
the whole multinational firm. Each transaction is valued in
terms of its contribution to the value chain. The complex
integration required to locate various functional activities -
not only production but also research and development,
finance, accounting, etc., where they can be more
successfully performed according to the strategy of the
multinationals (UNCTAD, 1993). Under the complex
integration model, there is an interrelationship between
functions, processes and various territories in which the
 Journal of Finance and Economics
MNE operates. However, not all elements of the value
chain are integrated in the same grade (Figure 3).
4. Multinational Firms Transfer Pricing
and Taxes
Due to the growth of FDI and increased activities of
multinational firms, a greater number of activities in the
value chain of enterprises groups of companies take place
in different countries. This generates complex questions
Figure 3. Strategies of complex integration
Source: UNCTAD (1993).World Investment Report 1993, Transnational Corporations and Integrated International Production, New York, No.
E.93.II.A.14 Graphic V.3, p. 120.
In a tax system based on residence, a country will
include in its tax base all or part of the revenue, including
revenue generated outside the country, by any person or
entity considered a resident in that jurisdiction. In a tax
system based on the origin, a country includes in its tax
base all or part of the revenue generated within their tax
jurisdiction, regardless of the taxpayer's residence. Often,
because these systems are applied together, it is given to
treat each independent entity within the group of
multinational firms. The OECD member countries have
adopted this approach, of independent entities as the most
reasonable to achieve equitable outcomes and to minimize
risks of double taxation. Thus, each group member is
subject to a tax on income derived from the country of
residence, based on the origin (OECD, 1993).
To apply the approach of independent entities, when
goods cross borders through the internal channels of
multinational firms, it is necessary for tax purposes to
agree in a transfer price. Transfer prices are the prices at
which companies transfer tangible and intangible goods,
or provide services to related parties (OECD, 1993).
However, when tax rates differ among the jurisdictions in
which they operate, the multinational firms have an
incentive to agree on transfer price so as to reduce their
tax burden, reporting higher profits in the country where
the profits are recorded more slightly (Bernard and Weiner,
1990). The number of multinational firms that agree upon
64
about where taxable income is generated by multinationals,
as this is distributed among firms located in different
countries, and as distributed taxes paid on this income
between tax jurisdictions (UNCTAD, 1993). To answer
these questions, it is necessary to know the position of tax
authorities regarding tax rates applicable to multinationals
operating in two or more tax jurisdictions. The tax rates of
each country will depend on whether the country uses a
tax system that is based on residence, based on the origin,
or both.
transfer prices in a way that minimizes their tax liability is
restricted by the regulations of their countries of origin
and host countries, and, the tax authorities' ability to
enforce these regulations (Bernard and Weiner, 1990).
In the specific case of Mexico, the laws applicable to
transfer pricing are found in Articles 86 paragraph XII,
XIII and XV, 215, 216, 216-bis and 217 of the Income
Tax Law. Article 215 of the Income Tax Law establishes
the use of arm's length principle ("arm's length principle")
to evaluate the transfer pricing agreed with related party
abroad. Article 216 establishes the transfer pricing
methods that taxpayers may use to assess compliance with
arm's length principle.
Article 86, Section XV, establishes the hierarchy of
transfer pricing methods in the order laid down in Article
216, starting with the traditional transactional methods:
Comparable uncontrolled price method (Método de
precio comparable no controlado, "MPC"), compares the
price agreed in the related party transactions to the price
agreed with /or between independent parties in
comparable transactions.
Resale price method (Método de precio de
reventa,"MPR"), compares the gross profit obtained when
an entity sells products to a party related to the gross profit
obtained with / or between independent parties in
comparable transactions.
65 Journal of Finance and Economics
Added cost method (Método de costo adicionado,
"MCA"), which is used to determine the selling price of
goods, the provision of a service or compensation of any
other transaction between related parties, multiplying the
cost of goods, services or the operation concerned, by the
result of adding to the unit the gross profit percent that
would have been agreed with/ or between independent
parties in comparable transactions.
On the other hand, there are transactional methods
based on utilities:
Utility partition method (Método de partición de
utilidades "MPU"), which is applied to allocate operating
income obtained by related parties in the proportion that
had been allocated to/ or between independent parties.
Residual method of utilities partition (Método residual
de partición de utilidades "MRPU"), which is applied to
allocate minimum operating income obtained by related
parties in the proportion that had been assigned with / or
between unrelated parties, and then determine the residual
value of the transaction. The residual profit is allocated
among the related parties involved in the operation taking
into account, significant intangibles used by each, in
proportion as it had been distributed with / or between
independent parties in comparable transactions.
Transactional margin method of operating income
(Método de márgenes transaccionales de utilidad de
operación "MMTUO"), which is used to identify related
party transactions, income from operations that have
obtained comparable companies or independent parties in
comparable transactions and operations, based on factors
that take into account profitability variables such as assets,
sales, costs, expenses or cash flows. These methods fulfill
the application of arm's length principle set forth in the
Guidelines Applicable to Transfer Pricing for
Multinational Enterprises and Tax Administrations of the
OECD.
5. Minimizing Tax Burden through
Transfer Pricing
Politicians constantly worry about the difference
between the tax rates of countries, particularly fear that if
tax rates are too high may lose economic activity,
discourage investment, which can be moved to countries
with lower tax rates (Bartelsman and Beetsma, 2001). As
the government needs to ensure that in designing their tax
systems, maintain their tax base and provide a favorable
climate for business and investment (UNCTAD, 1993).
However, the difference between the tax rates not only
induces shifts in the business, but also can generate
countable income shifts between firms across countries.
These income shifts are not prominent in the political
debates. However, if politicians were concerned about the
shift of income, so it's about moving countable income of
industrialized economies to the so-called "tax havens"
small countries with very low rates of corporate taxes
(Bartelsman and Beetsma, 2001).
The empirical analysis developed by Bartelsman and
Beetsma (2001), shows the import of the shift in income
between industrialized economies as a result of
differences in tax rates. There are two ways in which
multinational firms can shift their income from countries
with high tax rates to countries with lower tax rates. First,
the financial structure of the subsidiaries is relevant to the
taxation of multinationals. In particular, it is relatively
more attractive financing to subsidiaries in countries with
high tax on credit, instead of capital, with loans extended
by the parent or other subsidiaries in different countries.
The second channel for income shifting through borders
refers to prices that are used in inters firm transactions in
the international trade in goods and services (Bartelsman
and Beetsma, 2001).
Many times it is difficult to put into practice the strict
application of arm's length principle. For example, for
many transactions inter firm there is no comparable
transactions between third parties independent or not.
Therefore it is difficult to apply a traditional transactional
method. Thus; multinational firms can reduce their tax
liabilities reporting transfer prices as low as possible. The
shift of income leads to differences between reported
income and the "true" income generated in the business.
The usefulness of the reported production is reduced or
increased in countries with relatively high or low taxes,
because the companies agree lower or higher prices than
the market in their inter firm transactions (Bartelsman and
Beetsma, 2001).
6. Conclusion
Multinationals are firms that operate with FDI,
generating value-added activities in different territories.
Multinationals make the decision to locate in certain
countries because it has the opportunity to exploit
comparative advantages of these countries, so it is no
longer possible to consider the multinational firms as an
isolated unit but rather as a group of firms operating in a
global context.
Organizational strategies of multinational firms
generate inter-firm trade across borders, so that
multinational firms are forced to agree a transfer price to
exchange goods and services. This has created challenges
and opportunities for governments and multinational
corporations, especially in fiscal matters. For this reason
the tax authorities of more than 60 countries have adopted
regulations regarding transfer pricing, which are based on
the principle of full competition, and the traditional
transaction methods and based on earnings embodied in
the Guidelines Applicable to Mater of Transfer Pricing for
Multinational Enterprises and Tax Administrations of the
OECD.
However, due to the existence of different tax rates
between different jurisdictions in which a multinational
firm may operate, there is an incentive for these agreed
upon transfer prices as low as possible, and thereby it
displaces the extra revenue to the jurisdictions with a
lower tax rate. For this reason it is necessary that the tax
authorities apply more efficient regulations on transfer
pricing to avoid the tax bases of governments to be eroded
by such strategies put into practice by multinational firms.
Intergovernmental agreements between the involved
nation-states to regulate operations and activities of
multinational firms should emerge to have cross-national
policies to control on issues such as accounting guidelines
and procedures, investments, financial accountability, tax
and profits, transfer of prices and social corporate
responsibility.
 Journal of Finance and Economics
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